Economic Regulation

What is the future for the economic regulation of airport charges and can LATAM learn any insights from Europe?

Airports around the world are currently suffering the consequences of huge reductions in traffic and revenues due to the effects of the Covid pandemic. This has stress-tested some of the potential problems in the models for economic regulation and the management of concession contracts.

One particular region where the constraints of the existing models are under pressure is Latin America, where there are a high proportion of airports managed under concession contracts. Under these concessions, airport charges tend to be prescribed within the concession agreement (as well as infrastructure investments and other concessionaire commitments).

Increasingly, grantors and concessionaires in the region are looking at how the existing models can be adapted and the European experience is viewed from afar as a potential source for more flexible solutions. However, does the European experience provide the answers? Here we compare the different approaches.

The typical LATAM model

The typical LATAM model for airports under long-term concession is the Price Cap (Figure 4), which tends to prescribe airport charge adjustments as a formula included in the contract at the beginning of the period. This model assumes that the airport charges increase based on several factors (inflation – I, productivity factor – X, or quality factor – Q).

Figure 1. Main components of a Price Cap model

This approach tends to rely on assumptions established before the concession starts about the long-term financial projections of the concessionaire’s business plan, capital expenditure obligations, contributions to the grantor and the expected return on investment. Although there may be a degree of sensitivity for variations built into the forecasts, it does imply that there is a degree of perfect foresight of future traffic and profits 20, 30 or 40 years into the future.

This approach reduces the need for regulatory approval, but it can be somewhat rigid and highly susceptible to real-world deviations from the forecasts. Once the concession has started, this approach primarily controls prices rather than profits and the concessionaire carries the traffic risk. This can be very good news for the concessionaire in the good times when they are able to out-perform their original traffic forecasts and business plan.

However, due to the COVID-19 pandemic, airports under the Price Cap model have seen their forecasts (both traffic and business plan) substantially deteriorate, whilst time runs out for them to recover before the end of the concession period. These massive changes in the market conditions are not easily resolved within the framework of the concession agreements (and the price cap formula). In many cases, this could imply the failure of the concession unless the grantor agrees to re-negotiate the terms and length of the agreement.

As a result, grantors and concessionaires are looking for more flexible solutions, either to renegotiate existing concessions, or to re-tender a new replacement concession. So, does the European experience provide a panacea?

Economic Regulation in Europe

There are many different economic regulatory frameworks. In Europe, frameworks that are compliant with the EU Directive (and in effect the ICAO Policies) should have an underlying element that is cost-reflective, allowing the airport operator to make a “fair” return. With “heavy” regulatory approaches such as Rate of Return or Cost of Service, this is more explicit, but for “lighter touch” alternatives, such as Trigger Regulation, or Airline Consultation / Arbitration, the underlying or fall-back approach tends to still be referenced to cost recovery or rate of return.

The Rate of Return approach allows the airport to earn sufficient revenue to cover its costs and to provide a reasonable rate of return on capital investment (Figure 2) and is usually calculated looking forward over regulatory periods of between 1 to 5 years.

Figure 2. Schematics of a Rate of Return approach using building blocks

Under normal market circumstances, this approach is quite flexible, relatively self-correcting, and it rewards the airport operator for undertaking capital investment. However, the Rate of Return model does not work so well with the extreme variations in traffic seen during the COVID-19 pandemic.

Figure 3. Yield forecast for a 5-Mpax, single-till airport that incurs a 75% traffic loss

In theory, with such a dramatic reduction in traffic, the Rate of Return model enables the airport operator to increase its charges, as there are fewer passengers to provide the same amount of revenue (Figure 3). However, in practice the timing of adjustments to charges are not automatic and in any case, such short-term increases would penalise the remaining airlines still operating services (whilst suffering the same effects of the crisis) and potentially create a disincentive for them to restore flights.

The random nature of the timing of the traffic reduction in relation to the phase of the regulatory cycle also affects the ability of the airport to increase charges to recover its costs. If the reduction happens before the beginning of a new regulatory period, it is easier for the airport to adjust its projections and justify an increase in airport charges. However, if the reduction occurs midway through a previously agreed regulatory period, the airport operator may not be able to re-adjust the agreed charges and may be expected to assume the traffic risk. The adjustments that are allowed in the next regulatory period may not be sufficient to compensate for the losses from the previous period, particularly if traffic has already recovered and if the regime is not backward-looking.

During the COVID-19 pandemic, the limitations of the Rate of Return model have become more evident and there is some debate on different options to improve future models to adjust airport charges, such as:

  • A more market-based approach that relies on “lighter touch” regulation or consultations (which would be more popular with airports)
  • The inclusion of market-based variables in Rate of Return models (e.g. adjusting depreciation and operating cost variables to reflect passenger volumes). This would have the effect of deferring revenue recovery from the period of low passenger volumes to the period when passenger volumes return.
  • The inclusion of other variables that relate to the opportunity cost of capacity (and infrastructure / slot congestion), as well incentives to reduce noise and emissions.

The European model will likely evolve to a more efficient, versatile model that accounts for the market conditions of the sector and that provides a better environment for future recovery and sustainable development.

For the concessions in LATAM, the solution could involve moving towards a more flexible model based on cost-recovery principles that is more compatible with ICAO guidelines, while applying the lessons learnt from the good and bad experiences in Europe. However, the transition from a price cap formula to a cost-recovery model will be time and effort-intensive and would require a significant learning curve for grantors, regulators, concessionaires and users. A heavy regulation model that is too burdensome and costly is not recommended. For example, the regulatory process for Heathrow Airport spans ~3 years, featuring a long consultation process (the regulatory review H7, starting in 2022, has already involved 43 reports from external consultants and further materials from the CAA, HAL and other stakeholders). As they might say “el burro grande, ande o no ande”!

 


About the authors
Robert Appleton is MBA from IESE and Bsc (Hons), Director of International Airport Consultant and the UK office at ALG. rappleton@alg-global.com
Urko Barroso is MSc in Airport Planning and Management and Senior Consultant at ALG. ubarroso@alg-global.com
For more insights, please check www.alg-global.com